Analytics

Monday, February 28, 2011

Invest Like a Company

Hey campers,

Only the second post and already I'm breaking a promise! I started a blog post about my first analysis, but it occurred to me that it was getting a bit too complicated and involved and actually it needed a bit of an explanation before I could really get into it. The last thing I want to do is overwhelm with bizarre terminology, so this post is going to be sort of a beginner's guide to what's important in value investing. Sorry, the in depth analysis will have to wait a bit!

First, I highly suggest you skim both Security Analysis and The Intelligent Investor by Benjamin Graham. Both are important and contain a lot of useful information, but I'll be perfectly honest- the first time you read them, you will miss out on a lot. This is why I say scan. I know when I first started reading these books I was pretty much at a loss. Now if you have a good understanding of finance, you may find these books more accessible than I did when I started from no financial background whatsoever. On the positive side, I managed to figure this stuff out-- I'm convinced that with enough motivation, even if you have little to no knowledge about the matter, you can too. Right now you should get familiar with the general principles: What is investing, why do value investors invest the way they do, etc.

The most important thing I'd like to discuss is something I've come to believe strongly in after the past few years. I am not sure if you will find this suggestion in any investment text thus far, but to me, it is priceless: you need to invest as if you were a business.

See, the stock market is not intended for individuals to invest in. Not really. Or rather, not for the average Joe. One of the worst tragedies of finance in the past 30 years was the push towards the 401k--the idea that everybody should be in the stock market: if you've got a job, you should have a portfolio. Blame the stock brokers, blame the media or any other number of culprits. The destruction of the pension system and the ushering in of a stock portfolio as a retirement plan is incredibly hazardous to most people's financial wellbeing. The stock market is intended for use by businesses, or wealthy individuals masquerading as businesses. It is not a place for working class people to seek retirement; it is a place that lubricates the process of businesses acquiring one another by providing a them a liquid market.

Let me explain a bit further. Suppose Pepsi decides that it wants to buy Quaker Oats. (A shocking supposition indeed!) Pepsi can begin to issue orders to purchase, in cash (just like you would do) as many freely available shares in the market of Quaker Oats, and as long as there are sellers out there, they will continue to acquire the company. However, just as possible, they can exchange their own shares in order to acquire Quaker Oats shares and similarly acquire the company in that way. In fact, this is the way that they chose to proceed.

Why does any of this matter?

1. A company examines other companies, not stock prices. An individual looks at stock prices and their profits and losses. If you buy a stock at $50, and the stock goes down to $25, you're sitting there looking at your brokerage statement. In the column of "Profit and Loss," it says "-$50,000 / -50.00%". If it's particularly cruel, it will display this in red ink. You realize that you've lost $50,000. You feel like the scum of the earth. You decide it's time to cut your losses because you simply cannot take the pain any more, the cruel indelible touch of red mocking your very soul.

And yet, what does being down 50% have to do with the value of the company which you own? At this point, nothing. Of course, no one ever wants to be down 50%. But, now, suppose that you are instead a company very keen on acquiring another company. You start to purchase shares of that company, and the price of the shares go down 50%. It's as if your favorite store is having a sale! 50% off! You would continue to buy, merrily knowing that you were getting a great deal on something you wanted.

Lesson #1: You are buying companies, not stocks. Determine what companies you want to own based on your own valuation, and use a low price as a reason to buy more, not run for the hills.

Now, this lesson may sound self-explanatory, but I promise you if you haven't lost money by buying high and selling low, you haven't been investing very long. I could talk all day about this, but when it comes down to it, emotions will ruin your investment strategy. When I first started my mood would immediately sour upon a loss, even a relatively short term one, and I would begin to look for reasons to sell subconsciously. We as humans are good pattern detectors but terrible predictors of the future, I have found, and we will weave patterns to sing whatever song we want, given enough desperation.

Next point-

A company tends not to have a huge amount of cash on hand when they start nibbling at companies they want to buy. A company rather intends to acquire the company based on its own future expected cash flow. In fact, most companies get ridiculed for keeping unnecessary amounts of cash on hand and not deploying it to better use by their investors. (I'm looking at you, Apple). So how is this relevant to you?

Well, suppose you have a nice $10,000 saved up, and you intend to invest it through your 401k. Your stock broker says "The time to buy is now!" and he throws your $10,000 into an index fund. The time that he does so is September 1st, 2008. Within two months, you would have lost so much money that you wouldn't have broken even until about 2 - 4 months ago. Now, imagine instead that, like a company, you invested $2,000 5 times, once per month over the next 5 months. You would have broken even in July of 2009, and be sitting on almost a 35% profit now. Consequently, during times when the market is headed upward, you will realize less profit than if you buy immediately, this much should be obvious- but the key is, as value investors we know that the short term oscillations of the stock market are unpredictable. By buying over time, we eliminate the need to know whether the market is going to go up, sideways, or down. It does not matter. Every time we, as a company, buy more of the stock we are interested in, we reexamine the fundamentals of the company, ensure that it is still the company we want, and we pull the trigger.

Lesson #2:Never buy all at once. Buy over time to eliminate short term risk.

And finally, something that we simply cannot emulate as individuals. This is why, despite it not being quite as tax advantageous as a tax deferred IRA (though this is debatable and I would be glad to talk about the tax advantages of a corporation at length some other time), I highly suggest you invest through a corporation. Why is this? Because you can perform corporate actions to raise capital and eventually use your corporation as collateral for purchases-- your investments become a living, breathing, entity of their own which can easily be transfered to any potential heirs without much hassle. Stock-for-stock mergers are particularly good, especially with covenants that insist that the acquired company hold on to shares of your company for a given period of time. Furthermore, it helps you mentally begin to consider yourself less as a stock buyer and more as a conglomerate of corporations. If others wish to invest through you, you can provide them the means to do so.

Lesson #3:Invest like a company by becoming a company. It's not expensive or difficult to set up a holding company and it will be tremendously helpful in the long run.

The real goal of all of this is to change the way we think of money. Many people consider a rich man to be one with a certain net worth. For some, this number is $1 million. For others, this number is $20 million. In my opinion, this is the way that poor people identify wealth. They see the lump sum and ignore the cash flow. This is an important concept to grasp as many of the future blog posts will be addressing cash flow as a primary concern for investing. A business is not a lump sum of cash, it is future expected cash flows. A rich person is instead identified by what sort of income they have coming in, not their net worth. Money is not a static quantity, it is a living, breathing entity that flows from party to counter party. This is perhaps why so many lottery winners end up penniless after a few years. They respond to their lump sum of cash by accruing massive recurring expenses. Before they know it, the money is gone and all that are left are the expenses.

I hope that if I impart nothing else it is the important of developing cash flow producing assets. If I have any say in the matter, you will never suffer this fate, dear reader! Reevaluate money, keep both eyes on cash flows, think like a corporation, not an individual, and grow rich with me.